Chapter 14, Problem 5P

Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $5000 on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of $800 or $1000 each year. After paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year.

a. Fill in the table below showing the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows.

b. Suppose you hold 10% of the equity of ABC. What is another portfolio you could hold that would provide the same cash flows?

c. Suppose you hold 10% of the equity of XYZ. If you can borrow at 10%, what is an alternative strategy that would provide the same cash flows?